SINCE I began to answer readers’ questions in this column one of the most regular requests has been for an explanation of where Scotland’s money might come from if it was to be independent.

I will get to that question in due course, but in the light of the current SNP leadership election, and the fact that whoever wins it will become the First Minister of the devolved government in Scotland I think a slightly different slant is required at this moment.

The National:

That is to explain where Scotland’s money comes from now, how this compares to Westminster, and what the problems that the differences gives rise to really are. It is my belief that unless any new first minister has a mechanism for tackling those problems then the pathway to independence will be much harder and longer, so please bear with me in this longer than usual column.

In practice, there are only three ways in which any government can raise money. They are from money creation, tax and borrowing. There are no other choices.

What very few people realise is that as far as Westminster is concerned by far the most important of these is money creation. As a matter of fact, money creation funds the Westminster government. That is because so long as that government has passed a legal budget that authorises what it plans to spend it can, using legislation that dates from 1866, always instruct the Bank of England to make a payment on its behalf, and that bank cannot refuse to do so.

Most especially, it cannot complain that the Government has no money in its bank account, and therefore has no means to make payment. Nor can it say that the Government must tax or borrow first before making the payment. It does instead have a legal obligation to provide the Government with an overdraft to make the payment that it has demanded be made and as almost all economists now agree, when a bank provides a person (including a government) with an overdraft new money is created.

Simply understanding this straightforward fact (because that is what it is) about the Westminster government’s ability to spend makes it clear that the claim that there is no money, much beloved of most Westminster ministers, is complete nonsense. The UK Government can, as a matter of fact, spend any amount it wishes so long as it legally decides to do so. It can never be short of money and any claim to the contrary is, to be blunt, untrue.

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Can you just keep spending, then?

It is also a known fact that if a government was to spend without limit then there would be inflation. As a result, a government like the one in Westminster has no choice but to tax. But, I stress, it does so not to fund its expenditure, because that has already been paid for by money creation.

Instead, it does so to reclaim the money that it is already spent into circulation in the economy. In that case, for a government like that in Westminster tax is first and foremost a mechanism to control inflation that also happens to tackle inequality, the repricing of goods and services if that is considered desirable, and that can be used to encourage or discourage certain types of economic activity. All of these things make tax a pretty amazing tool for economic management for a government like that in Westminster. But none of them make tax a source of funding. Westminster government spending is funded by money creation.

What is more, contrary to all popular belief, and the claims of far too many politicians, there is absolutely no obligation on such a government to balance its books. In fact, for it to do so would be an exceptionally bad idea most of the time. That is because a growing economy always needs more money in circulation and the only way in which that money can be put into circulation is by the Government spending it into existence and by then not taxing it back. In other words, government deficits are essential if we are to have the money supply that we need to keep an economy both going and growing.

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So, what about borrowing?

At one time, when UK money was backed by gold, there was in theory a limited supply of money that the Government could create and as a result the Government was required to borrow it if it wanted to spend more than its income from tax. As a result, the Government got used to providing people who wanted a safe place to deposit their savings with the opportunity to do just that, whether via government gilts or bonds, or by saving with NS&I, or by buying premium bonds.

Now that the Government is not constrained in this way, and it can create all the money that it wants (which it is what it did when using QE to pay for the global financial crisis in 2008 and the Covid crisis in 2020). There is no reason for a government like that in Westminster to borrow, because it can always create all the money that it needs. However, because people still like to save with the Government because it is such a secure place to save that opportunity is still provided. As a result, it looks as if the Westminster government borrows, but in practice it does not. It simply offers banks, pension funds, life assurance companies, foreign governments and individuals with the chance to save with it, which is something quite different from borrowing.

That, then, is the government funding situation in Westminster.

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What about Holyrood?

What then has to be stressed is that everything in Holyrood is completely different. To compare the two systems and pretend that the constraints in both are the same is a total political mistake. That is because there is one massive difference between the two systems.

The Westminster government has its own central bank, the Bank of England, which creates own currency called sterling, and it can create as much of that currency as it wishes, and there is no one to stop it.

In contrast, Holyrood does not have a central bank. Nor does it have its own currency. It cannot as a result create money. Holyrood can, in that case, only raise money in two ways. One is to tax and the other is borrowing.

The National: Holyrood chamber interior

It cannot be stressed enough how important this difference is. The UK Government is a money creator. Holyrood is a money user. As a result, Westminster has almost unlimited choices available to it. In contrast, Holyrood has incredibly constrained choices available to it. You cannot create a bigger or starker political contrast that that and yet vast numbers of people, including most politicians, pretend the performance of the two governments can be compared. In the circumstances in which they operate, that comparison is ludicrous.

What is more, not only can Holyrood only use tax and borrowing to fund its activities, but very large parts of the tax system in Scotland have also been out beyond its control because Westminster has decided that should be the case. Holyrood has some limited control over income tax. It runs a range of local taxes. Scotland’s VAT is supposedly paid to it, but no one has any way of knowing if that payment is right. And thereafter Westminster controls the purse strings.

On top of that, Holyrood’s borrowing powers are exceptionally limited, meaning that its opportunity to raise funds for investment or economic stimulus or to reorganise the economy by tackling inequality or underemployment through the running of deficits is incredibly constrained.

So what does that mean?

In that case and to be blunt, all the economic odds are stacked against any Scottish government succeeding with the task that it is being given by Westminster under the current devolution settlement. All Holyrood can really decide to do is slightly rearrange the way in which the money allocated to it by Westminster is spent.

I suggest that this is one of the biggest issues that those who now want to lead the SNP must address. Of course, the SNP’s goal is independence. No one doubts that. But the political reality of the moment is that whoever becomes the SNP leader will have to work inside this incredibly rigged political system that has been set up by Westminster to ensure that whoever runs Scotland (unless, maybe, it is a Scottish Labour government paralleling a Westminster Labour government) is bound to fail. In that case, important as the pathway to independence is in any debate to come, so too is it essential that any new SNP leader understands the challenge that face them in managing the Scottish economy within the existing constraints that are imposed upon them.

This means that just as much as they need to have a convincing plan for independence, they also need to have a convincing plan for devolution. It may even be that one is not possible without the other: Convincing the people of Scotland that its problems can be managed by a government committed to independence would now seem to be a pre-requisite of success for independence. For the SNP, and anyone else wanting to end Westminster rule, this requires at least five things.

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Five things the Government must do

First, Scotland has to have control of the taxation of income from wealth, and of wealth itself within the country. There is a major inequality problem in Scotland which the Scottish Government needs to be able to tackle. So, income on savings, capital gains taxes and inheritance tax need to be under Scottish control.

Second, Scotland needs to have control of National Insurance when it has responsibility of so much which is supposedly funded by this tax.

Third, the Scottish Government needs to be able to control the corporation tax rate in Scotland because unless it does it has no effective instrument for the delivery of its industrial policy.

Fourth, Scotland must have its own VAT system so that it has the economic data to manage its economy which that system supplies and has control of the rates of VAT, many of which are a present biased towards the better-off.

Lastly, Scotland must have improved borrowing powers. It must have the capacity to issue its own bonds that might fund its own programmes of investment in Scotland. It is wholly unfair that Scottish people are denied this opportunity to save with their own government to build infrastructure that they need for their own futures.

I want Scottish independence. I think Scotland can thrive as an independent country.

But I am also a realist. Devolution is here for the time being. Making devolution work is essential. In that case understanding how the Scottish Government is financed and how it can be set free to make choices that create a more level playing field between Holyrood and Westminster is also essential.

The tax and borrowing powers of Scotland should, in that case, be an essential item for debate within the current SNP leadership election. I hope that the issue will be raised.